Treading Carefully When Investing for College

Many well-intentioned parents want to save for their children’s future educational expenses. The mistake they often make, however, is putting money in
accounts in their child’s name (in so-called custodial accounts) or saving outside of retirement accounts in general.
The more money you accumulate outside tax-sheltered retirement accounts,
the less assistance you’re likely to qualify for from federal and state financial
aid sources. Don’t make the additional error of assuming that financial aid
is only for the poor. Many middle-income and even some modestly affluent
families qualify for some aid, which can include grants and loans available,
even if you’re not deemed financially needy.
Under the current financial needs analysis that most colleges use in awarding financial aid, the value of your retirement plan is not considered an asset.
Money that you save outside of retirement accounts, including money in the
child’s name, is counted as an asset and reduces eligibility for financial aid.
Also, be aware that your family’s assets, for purposes of financial aid determination, also generally include equity in real estate and businesses that you
own. Although the federal financial aid analysis no longer counts equity in
your primary residence as an asset, many private (independent) schools continue to ask parents for this information when they make their own financial
aid determinations. Thus, paying down your home mortgage more quickly
instead of funding retirement accounts can harm you financially. You may
end up with less financial aid and pay more in taxes.
Don’t forgo contributing to your own retirement savings plan(s) in order to
save money in a non-retirement account for your children’s college expenses.
When you do, you pay higher taxes both on your current income and on the
interest and growth of this money. In addition to paying higher taxes, you’re
expected to contribute more to your child’s educational expenses (because
you’ll receive less financial aid).
If you plan to apply for financial aid, it’s a good idea to save non-retirement
account money in your name rather than in your child’s name (as a custodial
account). Colleges expect a greater percentage of money in your child’s name
(35 percent) to be used for college costs than money in your name (6 percent). Remember, though, that from the standpoint of getting financial aid,
you’re better off saving inside retirement accounts.
However, if you’re affluent enough that you expect to pay for your cherub’s
full educational costs without applying for financial aid, you can save a bit
on taxes if you invest through custodial accounts. Prior to your child reaching age 19, the first $1,900 of interest and dividend income is taxed at your
child’s income tax rate rather than yours. After age 19 (for full-time students,
it’s those under the age of 24), all income that the investments in your child’s
name generate is taxed at your child’s rate.